Analyst: Discover’s Merchant Network Might Be a Good Buy for a Mobile-Wallet Provider

Should Discover Financial Services sell its network business? That’s the intriguing question raised by an analyst at investment-banking firm Keefe, Bruyette & Woods in a report assessing how mobile devices and related technologies are rapidly reshaping the payments industry.

Sanjay Sakhrani, a managing director at New York City-based KBW, argues in the report issued this week that Discover’s network business is undervalued. He doesn’t call outright for Discover to sell it, but he does note that it might be an attractive asset for a mobile-wallet provider or other tech company, such as Google Inc., eBay Inc.’s PayPal, Isis, Square Inc. or even Facebook Inc., seeking a beachhead in the currently card-dominated payments world. What Discover could bring to such providers is penetration of U.S. merchants equal to 98% of the Visa-MasterCard merchant base.

Discover already has shown a willingness to lend its network business to white-label uses, as it does with PayPal. “Clearly, at this point, Discover’s network has been viewed as the ideal partner (and perhaps the only partner) for these types of companies,” wrote Sakhrani, who was not available for an interview.

Riverwoods, Ill.-based Discover gets most of its revenue from consumer financial services such as lending through its branded credit cards and student loans, and has even branched into mortgages. But Discover has put considerable effort into expanding its network business in recent years. It signs big merchants directly, but has struck up agreements with about 100 U.S. bank card acquirers to bring acceptance of the Discover card to near parity with the Visa and MasterCard networks. Its deal with PayPal enables the leading online-payment system to be accepted at the point of sale.

Discover’s network business actually consists of three networks: the Discover credit card network, the Pulse debit network, and the Diners Club International network, which operates globally.

The advantages for a mobile-payments player in owning rather than licensing a closed-loop network such as Discover’s are several, according to Sakhrani. A big one is the recognition that wide-scale use of mobile devices for payments is going to take a long time, so owning an existing network could give a mobile-wallet provider an immediate and sizable foundation in the established card-payments industry.

Closed-loop networks such as Discover’s are hard to create from scratch, Sakhrani notes. Whoever owns such a network has full control and thus is more able to meet competitive challenges, and the owner has full access and control over transaction data. In addition, the owner might be able to strike up new partnerships with Visa and MasterCard card issuers that currently consider Discover a competitor to those brands, according to Sakhrani.

“Some might argue that Discover has not had a lot of success in signing banks to third-party deals, so why would others? A digital wallet owned by a technology company would not necessarily be a direct competitor to the bank’s credit card business as Discover is, and … an affiliation with a more technologically savvy company might open the company up to new customers and possible referrals on the lending side,” he wrote.

Of course, buying Discover’s network poses risks for a new owner. They include a possible high purchase price and a negative reaction from other networks if they sense a new threat. Sakhrani notes that MasterCard Inc. already has imposed its digital-wallet fee for charges to its cards that fund non-MasterCard wallets such as PayPal’s and Google’s.

“While the fee was relatively small, it was an indication that the incumbents are taking notice of the changing dynamics,” the report says. “This is why we believe it might make sense for the digital wallet to contemplate (in that scenario) directly setting up issuer partnerships.”

The big advantage for Discover and its stockholders in selling the network could be unlocking value that currently is masked by Discover’s bigger business lines. Based on its revenues and other financial measures, Sakhrani estimates Discover network business is worth at least $3 billion, including $1.5 billion for the Discover credit card network and $1.6 billion for Pulse and Diners Club combined.

“We do not believe there is a whole lot of value being ascribed to the Discover network when considering the valuation of DFS shares and in a takeout scenario, we believe DFS shares at this point in the cycle are worth a lot more than current levels,” he said. Discover’s shares have been trading at about $52 recently.

Discover declined comment on the KBW report.